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Objectives

Chapter 5 Classify overhead costs as unit, batch,


product or facility level.
Describe ABC and recognize typical
activities and cost drivers in an ABC
Activity-Based Costing system.
Calculate the cost of a product using ABC
and compare traditional volume-based
costing to ABC.
Evaluate the benefits and limitations of
ABC systems.

Activity Based Costing (ABC) Activity Based Costing


(Traditional) Activity-based
ABC is also known as transaction costing.
The basic premise in ABC is that overhead Volume-based costing provides an
costs that are caused by activities are allocation methods alternative to
traced to individual product units on the work best if the traditional methods.
basis of frequency of consumption of manufacturing By allocating overhead
environment includes costs on the basis of
overhead resources by each product.
mostly unit-level costs activities that lead to
Under the ABC system, the manufacturing (costs that vary with the overhead costs, this
overhead rate is determined by dividing the every unit produced or method is effective in
total costs of each overhead activity by the the volume of automated, diverse
total frequency for each activity. production). product environments.

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Cost Levels Unit-Level Costs
Unit-LEVEL COSTS are
As an alternative to traditional costing incurred each time a unit
is produced.
methods, ABC allocates overhead costs
Examples:
on the basis of activities that drive Supplies for factory
costs. To do this, it is important to Depreciation of factory
understand the level at which costs are machinery
incurred.

Unit- Batch- Product- Facility- Batch- Product- Facility-


LEVEL LEVEL LEVEL LEVEL LEVEL LEVEL LEVEL
COSTS COSTS COSTS COSTS COSTS COSTS COSTS

Batch-Level Costs Product-Level Costs


Unit-LEVEL COSTS are Unit-LEVEL COSTS are Product-LEVEL COSTS
incurred each time a unit incurred each time a unit are incurred for each type
is produced. is produced. of product produced.
Examples: Examples: Examples:
Supplies for factory Supplies for factory Salaries of engineers
Depreciation of factory Depreciation of factory Product development
machinery machinery costs
Batch-LEVEL COSTS Batch-LEVEL COSTS
are incurred for batches are incurred for batches
of goods produced. of goods produced.
Product- Facility- Facility-
Examples: LEVEL LEVEL
Examples: LEVEL
Salaries for purchasing COSTS COSTS Salaries for purchasing COSTS
Depreciation for setup Depreciation for setup
equipment equipment

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Facility-Level Costs Summary of Costs Levels
Unit-LEVEL COSTS are Product-LEVEL COSTS Unit-LEVEL COSTS are Product-LEVEL COSTS
incurred each time a unit are incurred for each type incurred each time a unit are incurred for each type
is produced. of product produced. is produced. of product produced.
Examples: Examples: Examples: Examples:
Supplies for factory Salaries of engineers Supplies for factory Salaries of engineers
Depreciation of factory Product development Depreciation of factory Product development
machinery costs machinery costs
Batch-LEVEL COSTS Batch-LEVEL COSTS
Facility-LEVEL COSTS Facility-LEVEL COSTS
are incurred for batches are incurred for batches
sustain general facility sustain general facility
of goods produced. of goods produced.
processes. processes.
Examples: Examples:
Examples: Examples:
Salaries for purchasing Salaries for purchasing
Insurance and taxes Insurance and taxes
Depreciation for setup Depreciation for setup
Salary of plant manager Salary of plant manager
equipment equipment

Assigning Overhead ABC in Service Environments


Costs Under ABC
ABC is every bit as
important for service
providers as it is for
manufacturing
companies.

It has gained widespread


acceptance in the service sector
(i.e., U.S. Postal Service).

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ABC in Service Environments ABC in Nonmanufacturing
Limitation: Since the type of work done by
Environments
service companies tends to be
nonrepetitive, cost analysis can be difficult
with ABC.
Instead of applying ABC to the cost of a
product or service, it can be used to
Limitation: Service-oriented companies determine the cost of providing a
tend to have proportionately more facility- particular nonmanufacturing activity,
level costs than do manufacturing firms. like payroll services.
Thus, facility-level costs are allocated Should a company continue processing
arbitrarily to goods and services (if at all). payroll in-house or to outsource?

Benefits of ABC Limitations of ABC

Cost High
Accuracy Measurement
Increases Costs
Better Control Time Consuming
Through Identification with Multiple Activity
of Costs Pools and Cost Drivers
If the market dictates prices, ABC
Better Day-To-Day Decision
implementation costs may
Making and Opportunities for
exceed the expected benefits of
Continuous Improvement
more accurate data.

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Who Benefits from ABC? Illustration
Non-
Cost Unit- Claus Co. has identified an activity cost
Distortions Level pool to which it has allocated estimated
Costs
???? overhead of P1,920,000. It has
Companies determined the expected use of cost
drivers for that activity to be 160,000
Benefiting inspections. Product X require 40,000
From ABC inspections and Product Y require 30,000
Higher %
Diverse,
of
inspections.
Complex
Products Overhead Requirement: Determine the overhead
assigned to Product X and Product Y.

Exercise Exercise
For many years, Dayan Company has used a manufacturing The direct material cost is P120 per unit. The
overhead rate based on direct labor hours. The new companys product and other operating information
accountant has suggested that the company may be able to are as follows:
assign overhead costs to products more accurately by using
an activity-based costing system. The accountant explains
No. of
that by creating an overhead rate for each production activity Qty. DLH DL time No. of No. of No. of
that causes overhead costs, the resulting product costs will Product Produced Used Cost Handled Setups Changes Parts
reflect an accurate measure of overhead cost. He was able to
Ah 50 100 P 6,000 20 5 3 6
identify activity centers to which overhead costs are assigned.
The cost pool amounts of these centers and their selected
activity drivers are: Buh 100 300 P 18,000 40 7 5 10
Activity Center Costs Activity Drivers
Materials handling P 60,000 1,200 times handled Requirement: Compute the unit costs for each
Scheduling and setups 80,000 400 setups product using activity-based costing.
Designing 10,750 100 changes
No. of parts 50,000 500 parts

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